Will Venture Capital Beat The Market In 2014?

The Initial Public Offering (IPO) Prospectus for Apple Computer Inc. in December 1980. A total of 5 million shares were offered to the public for $22 each. The total outstanding shares after the offering were 54,215,332. Apple's valuation after the IPO was over $1 billion. (54 million shares at $22.) (Photo credit: Wikipedia)

Venture capital used to be a great place to put money. But in the last 15 years, it has been a lousy investment. 2013 was the strongest year since 2007 for VC and there are promising developments ahead for 2014.

But VC has much further to go before it starts beating the S&P 500 when adjusted for risk. Nevertheless, if expectations for a strong 2014 IPO market are realized, a bubble could build up that would yield market-beating returns for VC in five years.

In a VC fund, limited partners -- such as insurance companies, pension funds, foundations, and endowments -- put money into a partnership and let the general partners decide which startups to fund and how to oversee their executives. For that privilege, the LPs pay 2% of their investment as a management fee and give 20% of any investment profits to the general partners.

The problem with VC is that it is very risky. Typically, only one in 10 portfolio companies is a big winner; about three of them may make back the investment; and the rest go out of business. Only one in 10,000 funded startups end up being worth over $1 billion.

With all the media attention paid to the tiny fraction of portfolio companies, you might think that VCs only invest in blockbusters like Facebook and Twitter. And in the 1990s, there were an awful lot of winners thanks to the popular love of investing in Internet startups and the much looser standards for initial public offerings.

VC returns peaked in 1999 -- the 10 year average internal rate of return for a VC fund in that year was 83.4%. The most recent data on 10 year IRRs -- 7.8% as of June 2013 -- suggests that VC is not worth the risk. During those 10 years, the S&P 500 rose 7.3% -- which was a much better investment when you consider that far fewer of its component companies perished.

Nevertheless, the general partners of the firms that invested in winning startups are rolling in dough. And thanks to a reviving IPO market for VC-backed IPOs in 2013 -- 82 such IPOs raised $11.2 billion according to the National Venture Capital Association -- a more solid base has been set for further IPO activity in 2014.

Twitter's IPO led the pack and it was joined by nine other Internet-related IPOs in the fourth quarter of 2013. Of the 24 total offerings in that quarter, 75% of the proceeds were from Internet-related IPOs with much of the balance from six biotechnology IPOs.

For 2014, VCs and CEOs expect more venture investment, a better IPO market, and higher investment returns, according to an NVCA survey. 59% of VCs and 57% of startup CEOs predict higher levels of 2014 venture investment -- well above the 27% and 43%, respectively, that they expected in 2013.

The VCs and startup CEOs expect to see winners and losers. The winners -- recipients of this increased investment -- include startups that offer products in Business IT (73% of respondents), Consumer IT (58%) and Healthcare IT (57 %). The losers include clean technology (62% expect a decrease in investment), medical devices (46%), and biopharmaceuticals (31%).

About half the survey respondents expect a better IPO market in 2014. IPO winners and losers are expected to match the investment ones. Specifically, 64% of VCs think there will be more IT IPOs while 43% and 53%, respectively, expect fewer life sciences and clean tech offerings.

When it comes to the valuations of startups, most VCs expect improvement. 62% see higher company valuations and 25% envision no change in valuations. But nearly all startup CEOs (84% of those surveyed), believe their companies will be worth more in 2014.

These survey results suggest two irrational decision frameworks in the VC business. First, there is the recency bias -- investors tend to think that if they had recent winners, the winners -- such as consumer and business IT -- will keep winning. Conversely, recent losers -- like cleantech and biopharma -- will keep losing.

Second, it is very difficult to separate hope from reality in startup investing. Expectations for higher valuations and an improved IPO market would obviously benefit all participants so there is nothing to lose from telling surveyors that they are more optimistic. After all, as insiders, their optimism might attract more investor interest which would fulfill their predictions.